When it comes to the US investment outlook, the outcome of the presidential elections will almost certainly rise to the top of investors’ list of concerns soon, bumping discussions about the timing of the next interest-rate move by the Federal Reserve to second spot. Our view is that as much importance should be given to the make-up of Congress as to the election victor. That is because the president has relatively little direct influence over the economy and therefore little direct influence over corporate profits. Congress, on the other hand, is the body that passes the laws and as the Dodd Frank Wall Street Reform and Consumer Protection Act and the Affordable Health Care for America Act show, legislation can have a significant impact on particular sectors.
Equities likely to continue of range-bound course
US equities have posted higher returns this year than most other developed markets despite persistent investor concerns about high valuations, already high margins and the prospect of higher interest rates. Political turmoil in Europe and the emerging markets and a strengthening Japanese yen have made the US the default safe-haven equity market. We see the US market as likely to continue on a range-bound course through the rest of the year, with any shocks recouped, but little chance of a break-out to significant new highs. While corporate margins are indeed high, they are unlikely to collapse before the next recession (which we believe is still distant). Equity valuations should be supported by low interest rates.
The returns of the various industry sectors have until now been driven primarily by dividend yields as investors have turned increasingly to equities for income (see Exhibit 1). Although yields are expected to stay low, the Fed should hike at least once by the end of the year, reducing the appeal of these bond proxies.
An additional concern over the medium term is that investor demand has pushed equity valuations so high that future total returns will inevitably be sub-par. For example, the S&P Utilities sector currently trades at around 18.3 times forward earnings estimates, compared to an historical average since 1985 of 13.7 times. While the extra 1.2% in dividends compared to the broad index is welcome, it appears to be insufficient when the expected earnings growth for the sector is the second worst among the S&P 500 sectors.
Exhibit 1: Sector returns and dividend yield
- GICS sectors and REITs
- Each dot represents one of the sectors making up the S&P 500, i.e. energy, materials, industrials, etc.
Sources: FactSet, MSCI, BNP Paribas Investment Partners, as of 24 August 2016
Three attractive sectors and growth stocks
Those sectors that should offer the best combination of relatively attractive valuations and/or earnings growth potential include financials (which should benefit from rising interest rates), consumer discretionary and information technology. Parts of the healthcare sector are at risk from increased regulation depending on the outcome of the election, but the overall weight of the sector in the US economy should nonetheless continue rising.
Growth stocks should recover from their year-to-date underperformance as yield pressures lessen and cyclically sensitive parts of the economy expand. This is also an environment where small and mid-cap stocks should outperform large caps. Both the Russell 2000 and Russell Midcap indices have modestly outperformed the S&P 500 so far in 2016, but valuations are reasonable, the earnings growth outlook is helped by strong domestic demand, and a modestly appreciating US dollar should hinder large caps.
Capped Treasury yields and steady spreads
Even as the Fed raises interest rates, ongoing or even increasing quantitative easing by other central banks will most likely keep a lid on longer-term US Treasury yields; foreign investors see the appeal of 150bp in extra income versus their own domestic bond markets (see Exhibit 2). Credit is likely to continue to outperform government debt as a slow, but steady US expansion keeps spreads within the same narrow range they have been in over the last year (February 2016 excepted).
Exhibit 2: US Treasury-German Bund spread and foreign Treasury demand
Sources: US Treasury, Bloomberg, BNP Paribas Investment Partners, as of 24 August 2016
Even if there are periodic shocks to the market and subsequent spread widening, we would expect a quick retracement, as has been the case for over a year. High-yield spreads tend to be more sensitive to any weakening in the economy, though much of the energy sector exposure has now been minimised. We expect default rates to rise only modestly and believe investors are currently being compensated for the credit risk they pose.